The Pros and Cons of S Corporations

Once you’ve made the decision to structure your business as a corporation (most likely for the liability protection a corporation offers), you still have a decision to make: Will you form a C Corporation or an S Corporation?

Tax concerns often play a major role in this decision. Like the partnership business structure, S Corporations do not pay any federal income taxes. Instead, the business’s profits and losses are passed through to the shareholders, who must then report the income and losses on their personal tax returns. Referred to as “single taxation,” this process differs from C Corporations, which face “double taxation.” That means C Corporations pay federal income tax, and any dividends paid to shareholders are taxed as well.

Although tax concerns are important, they don’t tell the whole story. The advantages of forming an S Corporation include:

Eliminating double taxation: In an S corporation, profits and losses are passed through to shareholders, and taxes are only paid once. Check with your state to see how it handles S Corporations. Some states do not recognize S Corporations and will tax such businesses as a regular C Corporation. Some states charge S Corporations a state tax, although the corporation will not have to pay federal tax.

Protection from liability: As the owner of an S Corporation, your personal assets are separate from the business’s assets and are therefore protected in case any judgments occur against the business.

More room for investors: S Corporations can have up to 100 shareholders.

Easier accounting rules: S Corporations without any inventory can use the cash method of accounting, which is much simpler than the accrual method. Check with your accountant about which option makes sense for your business.

Here are some disadvantages of forming an S Corporation:

Rules and fees: Like a C Corporation, S Corporations are required to file a number of official state and federal documents, including Articles of Incorporation and corporate minutes. They must also hold regular shareholder meetings and pay the required government fees.

Shareholder restrictions: Realize that if an S Corporation has shareholders, the shareholders will be taxed for any income the company has, even if they did not receive any portion of that income. (In a C Corporation, shareholders are taxed only if they receive dividends.) In addition, S Corporations are only allowed to issue one class of stock, which may discourage some investors.

Salary requirements: The Internal Revenue Service requires all officers and owners of an S Corporation to make a salary, even if the company is not yet making a profit. This could be problematic for new businesses struggling to make payroll. A “reasonable salary” is what a person with the appropriate skills needed for the position would be paid on the free market.